The following “Expertise Beyond the Numbers” blog post from SC&H Group’s Tax Services team discusses a recent tax ruling that has a tremendous impact on compensation deductions for professional services corporations

In a recent tax Court ruling, T.C. Memo 2016-20, the Court ruled that a professional services corporation was responsible for the negligence penalty related to unreasonable compensation.

The Court had disallowed approximately 15 percent of the petitioner’s year-end bonuses, assessed the corporate level tax therein, and then assessed the 20 percent penalty under Internal Revenue Code 6662 for the substantial understatement of tax.

Of note in this ruling, which was solely focused on the penalty and not the disallowance of the compensation deductions, was that the taxpayer had not specifically asked their national accounting firm to opine on the deductibility of their compensation payments.

The underlying reasons for the audit adjustments that triggered the accuracy-related penalty are:

The taxpayer had an annual practice of “zeroing out” book income and this practice was documented in their board minutes.

The taxpayer was viewed as failing the “independent investor test,” which is an often-cited doctrine in reasonable compensation cases.

The Service, and then the Court, did not consider the growth in fair market value of the taxpayer. Instead, they focused their analysis on the growth, or lack thereof, of retained earnings and book income during the audit period.

The taxpayer had never paid dividends or otherwise provided a return to its shareholders.

Compensation deductions are becoming an increasingly scrutinized issue for the Internal Revenue Service – for both C corporations like this taxpayer, as well as S corporations.

The main takeaway from this ruling? Careful planning and documentation of the issues surrounding your compensation plan – for employees as well as shareholders – is time well spent.